The phenomenon of choice overload—that individuals find too many choices perplexing and demotivating—is one of the most popular ideas in behavioral economics. Choice overload came to the forefront with Sheena Iyengar’s well-known study of chocolates and jams in a grocery store—too many options made shoppers disinclined to like or buy. The concept has also made its way into 401(k) investment lineups. Professor Iyengar and coauthors found that too many fund choices reduced plan participation and encouraged participants to gravitate toward familiar options like money market funds. (The 401(k) research, coincidentally, was made possible by a collaboration between Vanguard and Iyengar.)
Choice overload offered a strong critique of a central organizing principle of 401(k) plans—that an extensive list of investment options is the best way to maximize welfare for workers, and the larger the list, the better. Other research (including our own) showed that while some participants made reasonably effective use of extensive choice sets, a large group made erratic portfolio decisions—investing either at extreme asset allocations or with high levels of concentration or idiosyncratic risk. Sponsors designed complex menus under the hypothesis that participants had strong preferences for, say, investment contracts over stock index funds, mid-cap value managers over long bonds, and so on. In reality, most did not.
It’s still common today to talk about DC menu options in terms of choice overload. Yet, we’d argue that the time has come to retire the concept, given the growth of automatic enrollment and target-date funds in DC plans. As of year-end 2015, 78% of new entrants into Vanguard recordkept plans were in professionally managed allocations—either a single target-date fund (76%) or traditional balanced funds and managed accounts (2%). Among all participants, half (48%) were in a professionally managed allocation, either a single target-date fund (42%) or balanced and managed account options (6%).
If this trend continues, we anticipate that over two-thirds of all Vanguard participants will be in a professionally managed strategy, mostly a single target-date fund, by 2020. For these participants, there is no problem of choice overload. The process of choosing has been delegated to the target-date money manager or other advisor running an all-in-one portfolio.
What is underlying this change? The obvious explanation is the strong default effect of automatic enrollment. Automatic enrollment is increasingly common, and the most prevalent choice of a default fund for automatically enrolled participants is a target-date option. Because of inertia, participants stick with that option.
The other explanation, which has received less attention, is a streamlined choice effect. Many plans still offer voluntary enrollment, whereby participants must choose both a contribution rate and investment option. In these plans, the presence of target-date funds, particularly in the first tier of a menu, has radically streamlined the decision-making process for participants. Participants in these cases gravitate toward a single target-date option because it reframes investment choice from a complicated portfolio construction process to a single question: In what year do I expect to retire?
It’s a sign of the shifting choice architecture of U.S. DC plans. A default and a streamlined choice effect have trumped the problem of too much choice.
In this environment, as we argue in our paper on DC plan design,¹ the fundamental design principle underlying DC investment menus has changed. Given that many investors are no longer making active choices (either because of a default or streamlined choice effect), the menu becomes a decision aid, a way to frame choices, for the motivated investor. This is the small group of participants who have strong investment beliefs and who want to deviate from a professionally managed, all-in-one portfolio option.
To us, the end of choice overload in DC plans signals a new era. It marks the emergence of a more desirable model of decision-making than the “more choice is better” model of the traditional 401(k) —one in which more participants end up in professionally designed portfolios while allowing a smaller group with strong convictions to create their own way.
¹ Frank Chism, Kelly N. McShane, and Stephen P. Utkus, 2016. Constructing a defined contribution investment lineup: Four best practices. Valley Forge, PA: The Vanguard Group.
Note: Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target-date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target-date. An investment in target date funds is not guaranteed at any time, including on or after the target-date.